What Does Insolvency Mean For a Bank?

John Hempton questions Paul Krugman’s explanation of why banks like Citigroup are already effectively bankrupt, even though they’re still in business. Krugman says that as soon as a bank’s liabilities are bigger than its assets (that’s not technically true of Citigroup right now, but might very well be if Citigroup marked down its assets to their true market value), it’s “bust.” Hempton, by contrast, argues that it’s more complicated than this, for a simple reason: banks get a much bigger return on their assets (that is, their loans) than they have to pay for their liabilities (which include, among other things, their customers’ deposits). They earn, say, three per cent on their assets, while paying just one per cent on their liabilities, which means that as long as it can avoid a bank run, even a bank with bigger liabilities than assets can earn significant profits, profits that over time close the gap between assets and liabilities, so that after a few years, a supposedly “bust” bank can suddenly become solvent again, without any additional injections of capital. As Hempton points out, this is the way the biggest Japanese banks were able to return to solvency in the nineteen-nineties.

Now, this doesn’t mean that the current state of affairs is fine—the only reason a bank can avoid a bank run is because of myriad U.S. government guarantees. And as Hempton himself says, this math doesn’t say anything about whether we should take over technically insolvent banks. But Hempton’s analysis does speak to the fact that bank insolvency doesn’t always look like a typical corporate bankruptcy. Typically, when you think of a company being bankrupt, you think of it being unable to pay its bills or meet its payroll, being unable to get credit to order new inventory, and so on. Circuit City, for instance, is closing its doors because it literally doesn’t have the money to keep them open. But that’s obviously not the case with major banks, which have access to the Fed’s discount window (meaning it can borrow money to meet its obligations), and which are still generating significantly positive cash flow. They can be insolvent and still, in most respects, do business as usual.

Shutting a bank down is usually, then, in some sense a judgment call on the part of regulators. That’s O.K.: it’s an inevitable part of a fractional-reserve banking system with federal-deposit insurance. But many of the proposals for bank nationalization seem to imply that regulators should start declaring banks that are technically solvent (like Citigroup) insolvent, with the government getting to take all of the banks’ assets as a result of what regulators decide. (An alternative is what William Buiter proposed in Britain, which is having the government essentially pay to acquire the big banks.) This, at the very least, does seem like it creates room for political mischief. More important, having the government take over going enterprises will encourage investors to put their money in one of two places: mattresses or government bonds.